In this article which is the first of a four-part series we shall be running on active trading tips for forex traders, we shall look at how to trade the trend in forex. A lot has happened in the financial markets in the last two years. We have come to see terms like “quantitative easing”, stimulus and bailouts being used freely in the market. These describe all actions that have been taken by the world’s central banks to stimulate their local and global economies to shake-of any lingering blues from the 2008 global financial crisis. We have as a result, seen some very strong trends in some currencies. The Australian Dollar (Aussie), Japanese Yen and US Dollar are currencies which have seen very strong trends to the downside and upside respectively in the last few months. These strong trends do present good opportunities for traders who can enter at the right points to follow the trend direction. This is in keeping with the popular forex saying that the trend is the trader’s friend until it ends. This means that it is good trading practice to set trades to follow the trend and not go against it. As part of our active trading series where we seek to simulate the trade scenarios traders are confronted with every day, we will demonstrate how a trader can find trading opportunities in the midst of a strong trend. One common forex strategy utilized is a trend following strategy.
It has happened to us all before. We open the charts to see what the market holds in store for the day, and all that beams back to us is a confusing maze of candlesticks with no apparent pattern. When confronted with such a chart, the dilemma for the trader is whether to go long, go short or stay out of the market altogether.
Now to the untrained eye, it may all look pretty confusing, but it actually is not. Opportunities can be found in the midst of strong trends by following the steps set out below.
The first step is usually to establish that the asset has some form of a defined trend. This can be detected on a long term chart if we see the candlesticks that depict price movement making higher highs and higher lows (uptrend) or making lower highs and lower lows (downtrend).
There are basically two things that can happen when an asset is in a trend:
a) It will keep on trending strongly and only allow the trader to buy on dips and to sell any rallies.
b) The trend may dissolve into a period of consolidation, after which it either continues in the pre-existing trend, or experiences a reversal.
How to Trade a Strong Trend
A strong trend usually occurs when there is a very strong fundamental force driving the currency pair which lingers in the market for a long time. A clear example of this is the uptrend seen in the USDJPY for some time now after more than three years of downtrend and consolidation. Here, the fundamental trigger has been the economic policy thrust of the Prime Minister Abe-led government in Japan. When there is a strong trend in the asset, the best bet for a trader who wants to capitalize on what is going on is to buy whenever there is a dip in the price of the currency pair, or sell whenever there is a brief rally. What does it mean to sell a rally and buy on a dip?
1. Buying the Dips, Selling the Rallies
Buying a dip and selling a rally is simply a popular market lingo which means to buy low and sell high. The buying at lows is done in a currency pair that is in a strong uptrend, while selling at highs is done when the asset is in a downtrend. The driving force behind buying dips and selling rallies is that the price of an asset never moves in a straight line, but sometimes huffs and puffs along the way as it marches to its new levels. Such “huffs and puffs” as we call it are simply periods of profit-taking when traders who got into trades following the trend at an early stage have made some money and want to cash out some or all of it. At other times, some market events may make a good proportion of traders to have a rethink, or to re-evaluate positions before continuing to hold on to them. Sometimes there is a little of trade exiting and the entrance of new traders or addition to existing positions by those who still believe there is more money to be made on the trend. All these account for the brief periods when there are pullbacks that present the opportunity to either buy on dips or sell on rallies.
Now is it wise to simply buy on dips and sell on rallies? No. The dips must be buyable and the rallies must be sellable, otherwise what the trader may think was a dip to be bought or a rally to be sold may turn into full-fledged trend reversals which will cause the trades to end on the losing side. It is therefore good practice to use confirmatory filters for such trades. One way I do this is to look for the following:
a) Where such a retracement dip or retracement rally exists. For this, I use the Fibonacci retracement tool. I also consult lower time frame charts to confirm that there is indeed a retracement going on. If you use the daily chart for this, there may be some confusion as candles may be too close together to allow for visualization of clear retracements. Sometimes, only a single candle will show this retracement action, but if the lower time frame chart is used, what may look like a small single candle movement may well be a 300 pip retracement! Do not forget that in a daily chart, one candle represents the price activity for a whole trading day.
b) If the time is right to buy a dip or sell a rally. This is best deciphered by using oscillators that show where the asset is oversold or overbought. My favourite here is the Stochastics oscillator set to 10,3,3 which shows oversold status at 25 or below, and overbought status at 75 and above.
It is quite easy. Apply the Fibo retracement tool from swing high to low (downtrend) or from swing low to high (uptrend). Then apply the Stochs oscillator, and look for where the price hits a retracement level when the asset is oversold to buy the dip, or when the asset is overbought to sell the rally.
Buy the dip…
Sell the rally…
Remember to always buy the dip in an uptrend, and sell the rally in a downtrend. Do not get these mixed up.
2. Trading the Breakouts
As identified earlier, there will be periods when the asset goes into consolidation as if unsure of what to do next. It may stay in consolidation for some time, presenting yet more opportunities to either buy low or sell high. Once the currency pair has made up its mind to keep moving like a traveller who just completed a stopover en route to the final destination, it takes off once more in the direction of the initial trend. This is a breakout, and is yet another way to trade a strong trend. This is all typified in this chart below:
We can see the initial trend, followed by a consolidation period and then a breakout. Within the area of consolidation, we can see the areas where the trader can buy on dips and sell on rallies. It is not hard to see why this is the case: there is a well-defined support and resistance, something which is not obvious if you are trading an active trend where the dip buying and rally selling points must be deciphered as described above. Furthermore, there are other chart patterns which are classical continuation patterns where the price consolidates within their boundaries and eventually breaks out. Such continuation patterns are the ascending/descending triangles, flags and pennants.
Here, we are more concerned with the breakout. In a breakout, the trader is actually buying into highs and selling into lows, a direct opposite of the dip and rally trade described above. You could call it selling the dips and buying the rallies. But why would this be another trade strategy for trading the trend?
Breakouts are usually the result of market fundamentals driving the asset in the direction of the initial trend. It could be due to a high-impact news release which drives traders into mass buying or selling following a period of waiting (the consolidation). It could also be due to technical plays where more players in the market assume a buying posture than a selling one (ascending triangle, bullish flag, bullish pennant) or assume a selling posture than a buying one (descending triangle, bearish flag, bearish pennant).
Whatever the case, a breakout presents fantastic trade opportunities. We have written about this in some of our earlier posts. It is easy to confirm if an asset has truly broken out or merely performed a fakeout move. Refer to our article on breakout trading to refresh your memory about how to identify a true breakout (which is tradable) and a fakeout (which is a trap).
The chart below shows the picture for the USDJPY. After a period of consolidation, it made a major breakout to the upside and has not looked back since.
We can clearly see the breakout bullish candle which produced the key to trade entry.
In summary, when you open your charts for the day, first determine what the trend for the asset is. Then assess its suitability for a breakout trade or for a buy on dip/sell on rally strategy. With a little practice on demo, the charts will not faze you anymore and you can then use the knowledge to make profits for yourself and transfer knowledge to others for a fee if you like.
The author’s views are entirely his or her own.